GMO: The Curious Incident of the Elevated Profit Margins
For the past decade, profit margins for U.S. firms have been elevated compared to their historic average. Predictions for a normalization of profit margins have yet to come true.
One possible explanation comes from increased leverage in the U.S. financial system. Permanent government deficits and big spending may be the major reason for higher corporate profit margins. Investors who expect this trend to continue can see high returns going forward. Those expecting a reversion back may expect lower prices.
From 1950 until 2000, profit margins for American businesses averaged between 5-7 percent. That moved into a 9-10 percent range by 2010.
One factor may be declining savings and increasing leverage. Essentially, households who save withhold money from the economy. With savings rates declining over the past few decades, there’s been more capital in risk markets like stocks.
With more capital to draw on, companies have been able to find more projects with a high profit margin.
However, no trend lasts forever. And it’s possible that corporate profit margins drop back to their historic average. But, if that happens, prices would need to fall substantially to keep valuations similar to where they are today.
Investors should be prepared for a substantial drop in stocks on a sustained decline in corporate earnings.